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Rich and Co.

Paradoxes in Trust, Investing and Rules Behavior

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…investment levels only rise with high levels of the rule.  However, this rise is not due to more trust… trust, measured by the value the investors place at risk (VAR), is reduced by the rule. While the relative amount invested increases with the highest rule, the rule itself prevents an overall increase in trust. This is consistent with the Replacement Hypothesis, with trust falling
when rules are exogenously imposed.

…higher return rates associated with higher rules are not a consequence of greater trustworthiness. Instead, any potential positive effects come indirectly from investors investing more. Overall, when rules are implemented, investment and trust both fall, which leads to lower return rates. As rules increase the minimum mandated return, investment rates rise
and, consequentially, return rates increase. However, trustworthy behavior never returns.

Despite evidence that they encourage higher relative investment in their extremes, higher rules inhibit the ability of investors to place themselves at risk and, hence, demonstrate trust…the only significant factor driving trustworthy behavior (defined as returning more than the mandated minimum) is the amount of trust demonstrated.

…investors can generate high returns by displaying trust. With…all of the reciprocity results from trustworthiness. Thus, trust elicits  trustworthiness. As larger minimum return rules are implemented, return rates drop on average and then finally rise.

The fall results from

(1) less trust displayed by investors and

(2) less trustworthy behavior by trustees given a level of trust

(i.e., the Replacement Hypothesis). As the rule rises, return rates rise. However,
this rise is driven by the higher mandated minimum returns. While investment
rises back up under the highest rule, the high minimum return inhibits
demonstrable trust. As a result, trustworthy behavior does not return.

Interactions that require trust involve a basic social dilemma where agents have to trade off self-interest and safety with the potential delayed benefits (both monetary and information) that arise from trusting and reciprocal behavior.

Trustees demonstrate trustworthiness by voluntarily giving back some of their profits to investors. On the other hand, failure to trust eliminates the potential monetary and informational gains realized after a trustee reciprocates. Effectively, this is a situation of nothing ventured, nothing gained.

While minimum return rules reduce downside risk for investors, they also limit the information generating potential of the exchange by constraining the amount that can be returned voluntarily.

Our results indicate both factors are important.

Overall, we find that by imposing rules on a trust based exchange, we disrupt an unambiguous demonstration of trust and reciprocity. Voluntary displays of reciprocity fall dramatically. The median investment level also falls when a minimum return rule is imposed. Further, by increasing rules’ restriction on discretionary returns, we show how demonstrated trust, investment, reciprocity, and economic welfare respond to increasingly restrictive rules. While investment levels and economic welfare rise under sufficiently restrictive rules, this does not represent a response to trust. It reflects the simple fact that investors invested more when they have less at risk.

Our findings that regulations may have adverse consequences are consistent with the literature on crowding-out of economic incentives.

We argue that, if a borrower repays a loan when there is no minimum payment, it would generate the most reputational information. Paying off the loan over time by making minimum payments mandated by a minimum payment rule inhibits reputation formation and, hence, may limit future opportunities that depend on credit ratings such as future loans, job opportunities, security clearances, etc. rules may increase economic welfare, they still reduce demonstrable trust and demonstrable reciprocity.

….not learning to trust because of restrictive rules in one context may inhibit trust and reciprocal behavior in other situations where trust relationships would be beneficial…When a system based solely on trust does not work efficiently enough to prevent opportunism, we often rely on rules that establish minimum standards. Although such rules prevent the worst abuses of trust relationships, they may also serve to calibrate expectations about socially acceptable behaviors, indicating what return rates are “good enough,” or they may serve as focal points, in which case behavior may effectively fall to the rule.

Therefore, the impact of rules on trust and reciprocity is ambiguous. Overall, we find that experimentally increasing a minimum return rule’s control over returns on investment inhibits trust and reciprocity. Trustworthiness, measured by the median level of voluntary discretionary returns to investors, virtually disappears with minimum rules.

…The median investment level also falls when a minimum return rule is imposed. While investment levels rise under sufficiently high minimum return rules, this does not represent a return to trusting behavior. It reflects the simple fact that investors have less at risk…instituting a (weak) rule has the unintended consequence of dampening exactly the behavior the institution was promoting. Thus, rules limiting investors’ downside-risk decrease both trust and reciprocal behavior. Only sufficiently restrictive rules increase investment in spite of the loss of trust.

….While imposing minimum requirement rules can create benefits, adding rules or enforcing them can also be counter-productive, as the day care and worker monitoring examples show. In fact, in some situations, removing or relaxing rules can improve outcomes. For example, ….removing curbs, lane markings, traffic signs, and other regulatory conventions, can improve traffic safety and reduce congestion.

…fewer rules can increase desirable behaviors, we show that rules depress the desirable behaviors that trustees would otherwise demonstrate. Recent studies suggest that vulnerability (or conflict of interests) is essential to the development of trusting relationships in organizational research…in research on cooperation in social dilemmas, and in understanding trust in close relationships. Similarly, we find that trust and reciprocity are strongest when investors have an opportunity to demonstrate their vulnerability and trustees can demonstrate that they have forgone opportunism. We believe the implications are clear: If a system based on trust is not broken or violations of trust are infrequent, it is not wise to tamper with it by imposing minimum standards of behavior. However, if a trust-based system is not functioning well in the absence of rules, it might be improved with the addition of rules, but only rules that sufficiently restrict opportunistic behavior.

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Written by Rich and Co.

November 1, 2015 at 3:29 pm

Posted in Uncategorized

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